FINANCIAL MANAGEMENT – THEORY
EXAM SEPT 24
1. Answer the following:
(a) Discuss any 2 advantages and 2 disadvantages of raising finance by issue of debentures. (4 Marks)
(b) List any four assumptions of Gorden’s Model. (4 Marks)
(c) What is Leveraged Lease? Explain. (2 Marks)
OR
(d) What are the remedies for over-capitalization? (2 Marks)
Answer
(a) Advantages of raising finance by issue of debentures are:
(i) The cost of debentures is much lower than the cost of preference or equity capital as the interest is
tax-deductible. Also, investors consider debenture investment safer than equity or preferred
investment and, hence, may require a lower return on debenture investment.
(ii) Debenture financing does not result in dilution of control.
(iii) In a period of rising prices, debenture issue is advantageous. The fixed monetary outgo decreases in
real terms as the price level increases. In other words, the company has to pay a fixed rate of interest.
Disadvantages of debenture financing are:
(i) Debenture interest and the repayment of its principal amount is an obligatory payment.
(ii) The protective covenants associated with a debenture issue may be restrictive.
(iii) Debenture financing enhances the financial risk associated with the firm because of the reasons given
in point (i).
(iv) Since debentures need to be paid at the time of maturity, a large amount of cash outflow is needed at
that time.
(b) Gordon’s model is based on the following assumptions:

Firm is an all-equity firm i.e. no debt.

IRR will remain constant, because change in IRR will change the growth rate and consequently the value
will be affected. Hence this assumption is necessary.

Ke will remain constant, because change in discount rate will affect the present value.

Retention ratio (b), once decide upon, is constant i.e. constant dividend payout ratio will be followed.

Growth rate (g = br) is also constant, since retention ratio and IRR will remain unchanged and growth,
which is the function of these two variables will remain unaffected.

Ke> g, this assumption is necessary and based on the principles of series of sum of geometric
progression for ‘n’ number of years.

All investment proposals of the firm are to be financed through retained earnings only.
(c) Leveraged Lease:

Under this lease, a third party is involved besides lessor and the lessee.

The lessor borrows a part of the purchase cost (say 80%) of the asset from the third party i.e., lender
and asset so purchased is held as security against the loan.

The lender is paid off from the lease rentals directly by the lessee and the surplus after meeting the
claims of the lender goes to the lessor.

The lessor is entitled to claim depreciation allowance.
OR
(d) Following steps may be adopted to avoid the negative consequences of over-capitalization:
(i) Company should go for thorough reorganization.
(ii) Buyback of shares.
(iii) Reduction in claims of debenture-holders and creditors.
(iv) Value of shares may also be reduced. This will result in sufficient funds for the company to carry out
replacement of assets.
2. Explain Angel Financing. (2 Marks)
ANSWER:

Angel Financing is a form of an equity-financing in which individual or a group of individuals provides
capital to entrepreneurs and early-stage businesses, or start-ups, in exchange for an ownership/equity
in the company.

They may provide a one-time investment or an ongoing capital injection via a series of investments,
Angel investors are looking for a higher rate of return than what is given by traditional investment.
EXAM MAY 24
1. Answer the following:
(a) State with brief reasons whether the following statements are true or false:
(i) Maximizing Market Price Per Share (MPS) as the financial objective which maximizes the
wealth of shareholders.
(ii) A combination of lower risk and higher return is known as risk return trade off and at this
level of risk-return, profit is maximum.
(iii) Financial distress is a position when accounting profits of a firm are sufficient to meet its
long-term obligations.
(iv) Angel investor is one who provides funds for start-up m exchange for an ownership/equity. (4
Marks)
(b) ABC Ltd. is approaching the banks for financing its business activity. You are required to describe
any four forms of bank credit for the consideration of the company. (4 Marks)
(c) Discuss the relevance of Payback reciprocal in capital budgeting decisions. (2 Marks)
OR
(d) Explain the features of crowd funding. (2 Marks)
Answer
(a)
Statement
Maximizing Market Price Per Share
True or False
True
Reason
Maximizing MPS or Market value as the
(MPS) as the financial objective which
financial objective will ensure the
maximizes the wealth of shareholders.
maximizing shareholder’s wealth.
A combination of lower risk and higher
False
There is a direct relationship between risk
return is known as risk-return trade
and profit. Higher the risk, higher is the
off and at this level of risk-return,
possibility of profits. Stockholders expect
profit is maximum.
greater returns from investments of higher
risk and vice-versa.
Financial distress is a position when
False
Financial distress is a position where Cash
accounting profits of a firm are
inflows of a firm are inadequate to meet all
sufficient to meet its long-term
its current obligations.
obligations.
Angel investor is one who provides
True
Angel Financing is a form of an equity-
funds for start-up in exchange for an
financing where an angel investor provides
ownership/equity.
capital for start-up or expansion, in exchange
for an ownership/equity in the company.
(b) Some of the forms of bank credit are: [ANY 4]
(i) Cash Credit: This facility will be given by the banker to the customers by giving certain amount of
credit facility on continuous basis. The borrower will not be allowed to exceed the limits sanctioned by
the bank.
(ii) Bank Overdraft: It is a short-term borrowing facility made available to the companies in case of
urgent need of funds. The banks will impose limits on the amount they can lend. When the borrowed
funds are no longer required, they can quickly and easily be repaid. The banks issue overdrafts with a
right to call them in at short notice.
(iii) Bills Discounting: The Company which sells goods on credit will normally draw a bill on the buyer who will
accept it and sends it to the seller of goods. The seller, in turn discounts the bill with his banker. The
banker will generally earmark the discounting bill limit.
(iv) Bills Acceptance: To obtain finance under this type of arrangement a company draws a bill of exchange
on bank. The bank accepts the bill thereby promising to pay out the amount of the bill at some specified
future date.
(v) Line of Credit: Line of Credit is a commitment by a bank to lend a certain amount of funds on demand
specifying the maximum amount.
(vi) Letter of Credit: It is an arrangement by which the issuing bank on the instructions of a customer or
on its own behalf undertakes to pay or accept or negotiate or authorizes another bank to do so against
stipulated documents subject to compliance with specified terms and conditions.
(vii) Bank Guarantees: Bank guarantee is one of the facilities that the commercial banks extend on behalf
of their clients in favour of third parties who will be the beneficiaries of the guarantees.
(viii) Short Term Loans: In a loan account, the entire advance is disbursed at one time either in cash or by
transfer to the current account of the borrower. It is a single advance and given against securities like
shares, government securities, life insurance policies and fixed deposit receipts, etc.
(c)

Reciprocal of the payback would be a close approximation of the Internal Rate of Return if the life of
the project is at least twice the payback period and the project generates equal amount of the annual
cash inflows.

The payback reciprocal is a helpful tool for quick estimation of rate of return of a project provided its
life is at least twice the payback period.

It may be calculated as follows:
Payback Reciprocal = Average annual cash flows/initial Investment
Or
Payback Reciprocal = 1 / payback period
OR
(d) Crowd funding:

Crowdfunding means raising money for an individual or organization from a group of people to fund a
project, typically via internet (social media and crowdfunding websites).

It generally involves collecting funds from family, friends, strangers, corporates and many more in
exchange of equity (known as Equity funding), loans (known as P2P lending) or nothing at all (i.e.
donation).

This source of funding also helps start-up to substantiate demand for their product before entering
into production.

In the crowdfunding process, three parties are involved i.e. fund raiser, mediator and fund investor.

The platforms (mediator) may also charge certain fees in the form of processing fee, transaction fee,
etc. either as a fixed amount or a percentage or in combination of both.
MTP JAN 25 (2)
1. Answer the following:
(a) EXPLAIN the difference between factoring and forfaiting (4 Marks)
(b) DESCRIBE some of the tasks that demonstrate the importance of good financial management
(4 Marks)
(c) EXPLAIN the concept of Drop – Lock Bond (DL Bonds). (2 Marks)
OR
(d) MENTION any one advantage of stock dividend – to the company as well as to the investor.
(2 Marks)
ANSWER
(a)
Particulars
Factoring
Forfaiting
A) Meaning
Factoring involves sales of receivables to
Forfaiting is a form of export financing
the financial institution called factor in
where the exporter sells the rights to
exchange for immediate cash payment
trade receivables to a forfaiter and
receives instant cash
B) Recourse or
May be on Recourse or Non-recourse
non-recourse
basis
Always non-recourse
Firms are generally paid 80% to 90%
100% on the value of exported goods is
C) Amount paid
upfront
paid
D) Type of
Receivables may either domestic or
Receivables are international
receivables
international
E) Cost
Factoring cost in the form of factor
Overseas Buyer bears the forfaiting
commission or fees is to be borne by the
cost, if any
seller
Factoring does not involve a secondary
Forfaiting has a secondary market
market for the receivables, meaning that
where the receivables can be traded,
F) Secondary
the transaction is complete once the
enhancing liquidity and providing
market
receivables are sold to the factor.
additional opportunities for investors
(b) Some of the tasks that demonstrate the importance of good financial management

Taking care not to over invest in fixed assets

Balancing cash-outflows with cash-inflows

Ensuring that there is a sufficient level of working capital

Setting sales revenue targets that will deliver growth

Increasing the Gross profit by setting the correct pricing for products or services

Controlling the level of general and administration expenses by finding more cost-efficient ways of
running the day-to-day business operations

Tax Planning that will minimize the taxes a business has to pay

A drop lock is an arrangement whereby the interest rate on a floating-rate note becomes fixed if it
(c)
falls to a specified level.

Above that level the rate floats based on a benchmark market rate, typically with a semi-annual reset.

In other words, drop lock bonds marry the attributes of both floating-rate securities and fixed-rate
securities.

The drop lock effectively sets a floor on the rate and a guaranteed minimum return to
Or
(d)
 Advantage to the Company - Stock dividends are suitable in the situation of cash crunch and
deficiency faced by the company and suitable when restrictions are imposed by lenders to pay the cash
dividend
 Advantage to the investor – Improves liquidity in the hands of the investors as bonus shares leads to
breaking down of higher priced shares into lower priced shares and hence give a choice to shareholders
to sell some of the lower priced shares and get some liquidity.
MTP JAN 25 (1)
1. Answer the following:
(a) A company is evaluating two options for financing its current assets: using short-term loans or
long-term loans. HOW should the company balance risk and return in making this decision, and
WHAT factors should it consider to ensure optimal financing? (4 Marks)
(b) You are a financial consultant for a company that has a very high capital base but low earnings
per share (EPS). EXPLAIN over-capitalization. What are the causes and consequences of overcapitalization?"
(4 Marks)
(c) "XYZ Corp. has adopted a strategy to maximize short-term profits by increasing product prices
significantly. ANALYZE why this might not be a feasible operational criterion for sustainable
growth." (2 Marks)
OR
(d) DEFINE Modified Internal Rate of Return method. (2 Marks)
ANSWER
(a)

The financing of current assets involves a tradeoff between risk and return.

A firm can choose from short- or long-term sources of finance.

Short term financing is less expensive than long term financing but at the same time, short term
financing involves greater risk than long term financing.

Depending on the mix of short term and long-term financing, the approach followed by a company may
be referred as matching approach, conservative approach and aggressive approach.

In matching approach, long-term finance is used to finance fixed assets and permanent current assets
and short-term financing to finance temporary or variable current assets.

Under the conservative plan, the firm finances its permanent assets and also a part of temporary
current assets with long term financing and hence less risk of facing the problem of shortage of funds.

An aggressive policy is said to be followed by the firm when it uses more short-term financing than
warranted by the matching plan and finances a part of its permanent current assets with short term
financing.
(b)
Over-capitalization and its Causes and Consequences
It is a situation where a firm has more capital than it needs or in other words assets are worth less than its
issued share capital, and earnings are insufficient to pay dividend and interest.
Causes of Over Capitalization
Over-capitalisation arises due to following reasons:
(i) Raising more money through issue of shares or debentures than company can employ profitably.
(ii) Borrowing huge amount at higher rate than rate at which company can earn.
(iii) Excessive payment for the acquisition of fictitious assets such as goodwill etc.
(iv) Improper provision for depreciation, replacement of assets and distribution of dividends at a higher
rate.
(v) Wrong estimation of earnings and capitalization.
Consequences of Over-Capitalisation
Over-capitalisation results in the following consequences:
(i) Considerable reduction in the rate of dividend and interest payments.
(ii) Reduction in the market price of shares.
(iii) Resorting to “window dressing”.
(iv) Some companies may opt for reorganization. However, sometimes the matter gets worse and the
company may go into liquidation.
(c)
“The profit maximisation is not an operationally feasible criterion.”

This statement is true because Profit maximisation can be a short-term objective for any organization
and cannot be its sole objective.

Profit maximization fails to serve as an operational criterion for maximizing the owner's economic
welfare.

It fails to provide an operationally feasible measure for ranking alternative courses of action in terms
of their economic efficiency.
It suffers from the following limitations:
(i) Vague term:

The definition of the term profit is ambiguous.

Does it mean short-term or long-term profit?

Does it refer to profit before or after tax?

Total profit or profit per share?
(ii) Timing of Return:

The profit maximization objective does not make distinction between returns received in different
time periods.

It gives no consideration to the time value of money, and values benefits received today and
benefits received after a period as the same.
(iii) It ignores the risk factor.
(iv) The term maximization is also vague.
OR
(c) Modified Internal Rate of Return (MIRR):

There are several limitations attached with the concept of the conventional Internal Rate of Return.

The MIRR addresses some of these deficiencies.

For example, it eliminates multiple IRR rates; it addresses the reinvestment rate issue and produces
results, which are consistent with the Net Present Value method.

Under this method, all cash flows, apart from the initial investment, are brought to the terminal value
using an appropriate discount rate (usually the cost of capital).

This results in a single stream of cash inflow in the terminal year.

The MIRR is obtained by assuming a single outflow in the zeroth year and the terminal cash inflow as
mentioned above.

The discount rate which equates the present value of the terminal cash inflow to the zeroth-year
outflow is called the MIRR.
MTP SEPT 24 (2)
1. Answer the following:
(a) The agency problem is one of the key concepts in corporate governance and financial management.
On the light of this statement, EXPLAIN agency problem, consequences of agency problem and
how to overcome the issue. (4 Marks)
(b) Operating leases and financial leases are traditionally the most important types of leases in
financial management. However, in recent years, other types of leases have also gained
significance due to their unique benefits and applications. IDENTIFY AND EXPLAIN at least four
other types of leases that have become increasingly important in modern business practices.
(4 Marks)
(c) EXPLAIN the Relationship between EBIT-EPS-MPS (2 Marks)
OR
(d) EXPLAIN Financial Leverage as a ‘Double edged Sword’ (2 Marks)
ANSWER
(a)

Though in a sole proprietorship firm, partnership etc., owners participate in management but
incorporates, owners are not active in management so, there is a separation between owner/
shareholders and managers.

In theory managers should act in the best interest of shareholders however in reality, managers may
try to maximise their individual goal like salary, perks etc., so there is a principal agent relationship
between managers and owners, which is known as Agency Problem.

In a nutshell, Agency Problem is the chances that managers may place personal goals ahead of the goal
of owners. Agency Problem leads to Agency Cost.

Agency cost is the additional cost borne by the shareholders to monitor the manager and control their
behaviour so as to maximise shareholders wealth.
Generally, Agency Costs are of four types:
1.
monitoring
2. bonding
3. opportunity
4. structuring.
Addressing the agency problem

The agency problem arises if manager’s interests are not aligned to the interests of the debt lender
and equity investors.

The agency problem of debt lender would be addressed by imposing negative covenants i.e. the
managers cannot borrow beyond a point.

This is one of the most important concepts of modern-day finance and the application of this would be
applied in the Credit Risk Management of Bank, Fund Raising, Valuing distressed companies.

Agency problem between the managers and shareholders can be addressed if the interests of the
managers are aligned to the interests of the share- holders.

It is easier said than done.
However, following efforts have been made to address these issues:
 Managerial compensation is linked to profit of the company to some extent and also with the long-term
objectives of the company.
 Employee is also designed to address the issue with the underlying assumption that maximisation of the
stock price is the objective of the investors.
 Effecting monitoring can be done.
(b)
(i) Sales and Lease Back:

Under this type of lease, the owner of an asset sells the asset to a party (the buyer), who in turn
leases back the same asset to the owner in consideration of a lease rentals.

Under this arrangement, the asset is not physically exchanged but it all happen in records only.

The main advantage of this method is that the lessee can satisfy himself completely regarding the
quality of an asset and after possession of the asset convert the sale into a lease agreement.

Under this transaction, the seller assumes the role of lessee (as the same asset which he has sold
came back to him in the form of lease) and the buyer assumes the role of a lessor (as asset
purchased by him was leased back to the seller).

So, the seller gets the agreed selling price and the buyer gets the lease rentals.
(ii) Leveraged Lease:

Under this lease, a third party is involved besides lessor and the lessee.

The lessor borrows a part of the purchase cost (say 80%) of the asset from the third party i.e.,
lender and asset so purchased is held as security against the loan.

The lender is paid off from the lease rentals directly by the lessee and the surplus after meeting
the claims of the lender goes to the lessor.

The lessor is entitled to claim depreciation allowance.
(iii) Sales-aid Lease:

Under this lease contract, the lessor enters into a tie up with a manufacturer for marketing the
latter’s product through his own leasing operations, it is called a sales-aid lease.

In consideration of the aid in sales, the manufacturer may grant either credit or a commission to
the lessor.

Thus, the lessor earns from both sources i.e. From lessee as well as the manufacturer.
(iv) Close-ended and Open-ended Leases:

In the close-ended lease, the assets get transferred to the lessor at the end of lease, the risk of
obsolescence, residual value etc., remain with the lessor being the legal owner of the asset.

In the open-ended lease, the lessee has the option of purchasing the asset at the end of the lease
period.
(c)

The basic objective of financial management is to design an appropriate capital structure which can
provide the highest wealth, i.e., highest MPS, which in turn depends on EPS.

Given a level of EBIT, EPS will be different under different financing mix depending upon the extent of
debt financing.

The effect of leverage on the EPS emerges because of the existence of fixed financial charge i.e.,
interest on debt, financial fixed dividend on preference share capital.

The effect of fixed financial charge on the EPS depends upon the relationship between the rate of
return on assets and the rate of fixed charge.

If the rate of return on assets is higher than the cost of financing, then the increasing use of fixed
charge financing (i.e., debt and preference share capital) will result in increase in the EPS.

This situation is also known as favourable financial leverage or Trading on Equity.

On the other hand, if the rate of return on assets is less than the cost of financing, then the effect
may be negative and, therefore, the increasing use of debt and preference share capital may reduce the
EPS of the firm.

The fixed financial charge financing may further be analysed with reference to the choice between the
debt financing and the issue of preference shares.
Theoretically, the choice is tilted in favour of debt financing for two reasons:
(i)
the explicit cost of debt financing i.e., the rate of interest payable on debt instruments or loans
is generally lower than the rate of fixed dividend payable on preference shares, and
(ii)
interest on debt financing is tax-deductible and therefore the real cost (after-tax) is lower
than the cost of preference share capital.
OR
(d)

When the cost of ‘fixed cost fund’ is less than the return on investment, financial leverage will help to
increase return on equity and EPS.

The firm will also benefit from the saving of tax on interest on debts etc.

However, when cost of debt will be more than the return it will affect return of equity and EPS
unfavourably and as a result firm can be under financial distress.

Therefore, financial leverage is also known as “double edged sword”.
Effect on EPS and ROE:
When, ROI > Interest – Favourable – Advantage
When, ROI < Interest – Unfavourable – Disadvantage
When, ROI = Interest – Neutral – Neither advantage nor disadvantage
MTP SEPT 24 (1)
1. DISCUSS the parameters of Lintner’s Model. (2 Marks)
ANSWER

Lintner’s model has two parameters:
a.
The target payout ratio,
b. The spread at which current dividends adjust to the target.
2. Answer the following:
(a) DISCUSS: the Costs of Availing Trade Credit (4 Marks)
(b) Briefly EXPLAIN the following –
i.
Fully Hedged Bonds
ii.
Medium Term Notes
iii. Floating Rate Notes
iv.
Euro Commercial Papers (4 Marks)
(c) WHAT is the range of DOL? (2 Marks)
OR
(d) DISCUSS the role of a chief financial officer. (2 Marks)
ANSWER
(a) Normally it is considered that the trade credit does not carry any cost. However, it carries the following
costs:
(i) Price: There is often a discount on the price that the firm undergoes when it uses trade credit, since it
can take advantage of the discount only if it pays immediately. This discount can translate into a high
implicit cost.
(ii) Loss of goodwill: If the credit is overstepped, suppliers may discriminate against delinquent customers
if supplies become short. As with the effect of any loss of goodwill, it depends very much on the
relative market strengths of the parties involved.
(iii) Cost of managing: Management of creditors involves administrative and accounting costs that would
otherwise be incurred.
(iv) Conditions: Sometimes most of the suppliers insist that for availing the credit facility the order should
be of some minimum size or even on regular basis.
(b)
(i) Fully Hedged Bonds:

In foreign bonds, the risk of currency fluctuations exists.

Fully hedged bonds eliminate the risk by selling in forward markets the entire stream of principal
and interest payments.
(ii) Medium Term Notes (MTN):

Certain issuers need frequent financing through the Bond route including that of the Euro bond.

However, it may be costly and ineffective to go in for frequent issues.

Instead, investors can follow the MTN programme.

Under this programme, several lots of bonds can be issued, all having different features e.g.
different coupon rates, different currencies etc.

The timing of each lot can be decided keeping in mind the future market opportunities.

The entire documentation and various regulatory approvals can be taken at one point of time.
(iii) Floating Rate Notes (FRN):

These are issued up to seven years maturity.

Interest rates are adjusted to reflect the prevailing exchange rates. T

hey provide cheaper money than foreign loans.
(iv) Euro Commercial Papers (ECP):

ECPs are short term money market instruments.

They have maturity period of less than one year.

They are usually designated in US Dollars.
(c)

DOL can never be between zero and one.

It can be zero or less or it can be one or more.
(i) When Sales are much higher than BEP sales, DOL will be slightly more than one.
(ii) With decrease in sales, DOL will increase.

At BEP, DOL will be infinite.
(i) When sales are slightly less than BEP, DOL will be negative infinite.
(ii) With further reduction in sale, DOL will move towards zero.

At zero sales, DOL will also be zero.
OR
(d) The finance executive of an organisation plays an important role in the company’s goals, policies, and
financial success. His responsibilities include:
(i) Financial analysis and planning: Determining the proper amount of funds to employ in the firm, i.e.
designating the size of the firm and its rate of growth.
(ii) Investment decisions: The efficient allocation of funds to specific assets.
(iii) Financing and capital structure decisions: Raising funds on favourable terms as possible i.e.
determining the composition of liabilities.
(iv) Management of financial resources (such as working capital).
(v) Risk management: Protecting assets.